Basic problems of an economy | ISC Class 11 Economics Notes

This note covers the economic problem of scarcity and choice, why this problem is universal and faced by every economy whatever its economic system, the three basic problems of an economy (what, how and for whom to produce), the efficient use of resources, the production possibility curve with its assumptions and features, opportunity cost, and how technology causes a shift or a rotation of the production possibility curve.

What is the economic problem of scarcity and choice?

Every individual and every society needs many goods and services in everyday life, such as food, clothing, shelter, transport and education. No individual has all these things to begin with.

A family farm may own land, grain and farming tools; a weaver may have yarn and cotton; a teacher has only the skill to teach.

Each decision-making unit uses the resources it has, meaning the goods and services used to produce other goods and services, such as land, labour, tools and machinery.

No individual has unlimited resources compared with her needs. This is scarcity. Because resources are scarce, a person can have more of one good or service only by giving up some amount of another.

A family that wants a bigger house may have to give up a few more acres of arable land; a family that wants more and better education for the children may have to give up some luxuries.

Every individual therefore faces scarcity and must use limited resources in the best possible way, which is the problem of choice.

Just as individuals face scarcity, the resources of a whole economy are limited compared with what people collectively want.

The scarce resources of the society have to be allocated properly among the production of different goods and services, keeping in mind the likes and dislikes of the people.

The allocation of the limited resources and the distribution of the final mix of goods and services among individuals are the two basic economic problems faced by any society.

Definition: Scarcity. The situation in which the resources available to an individual or a society are limited in comparison with the wants they are needed to satisfy.

Why is the problem of scarcity and choice universal?

The problem of scarcity and choice is universal in character: it is faced by all economies, irrespective of the economic system they follow.

A rich country and a poor country, a market economy and a centrally planned economy, all have resources that are limited compared with what their people collectively want.

What differs between economic systems is only the way the problem is solved: basic problems can be solved either by the free interaction of individuals pursuing their own objectives, as in a market, or in a planned manner by a central authority such as the government.

In a centrally planned economy the government or central authority plans all the important activities and makes the important decisions about production, exchange and consumption.

In a market economy all economic activities are organised through the market, and prices send information that coordinates the decisions of buyers and sellers.

In reality all economies are mixed economies, where some important decisions are taken by the government and economic activities are by and large conducted through the market; the only difference is the extent of the government's role.

Because scarcity and choice remain in every one of these systems, the basic problem is universal, and it is explained with the help of the production possibility curve.

What are the three basic problems of an economy?

Production, exchange and consumption of goods and services are the basic economic activities of life. Because resources are scarce and have competing usages, every society has to decide how to use them. The problems of an economy are usually summarised under three questions.

What is produced and in what quantities?

Every society must decide how much of each of the many possible goods and services it will produce: whether to produce more food, clothing or housing, or more luxury goods; whether to have more agricultural goods or more industrial products and services; whether to use more resources in education and health or in building military services; whether to have more basic education or more higher education; and whether to have more consumption goods or more investment goods, such as machines, which will boost production and consumption tomorrow.

How are these goods produced?

Every society has to decide how much of which resource to use in producing each good or service: whether to use more labour or more machines, and which of the available technologies to adopt in the production of each good.

For whom are these goods produced?

Who gets how much of the goods produced in the economy, and how should the produce be distributed among individuals? Who gets more and who gets less? Whether or not to ensure a minimum amount of consumption for everyone, and whether elementary education and basic health services should be available freely for everyone in the economy.

Together, the allocation of scarce resources to the production of different goods and services, and the distribution of the produced goods and services among individuals, are the central problems of any economy.

What is meant by efficient use of resources?

An allocation of the scarce resources of an economy gives rise to a particular combination of goods and services.

Given the total amount of resources, it is possible to allocate them in many different ways and thereby achieve different mixes of goods and services.

The collection of all possible combinations that can be produced from a given amount of resources and a given stock of technological knowledge is called the production possibility set of the economy.

Resources are used efficiently when the economy is producing on its production possibility frontier rather than inside it.

A point lying strictly below the frontier represents a combination that is produced when all or some resources are either underemployed or are used in a wasteful fashion.

Efficient use therefore means that resources are fully and properly utilised, so that the economy cannot produce more of one good without producing less of another.

Definition: Efficient use of resources. The use of scarce resources in such a way that the economy operates on its production possibility frontier, so more of one good can be produced only by giving up some of another.

What is a production possibility curve, and what are its assumptions?

Consider an economy that can produce corn or cotton by using its resources. The table below gives some of the combinations of corn and cotton that the economy can produce when its resources are fully utilised.

If all resources are used to produce corn, the maximum amount of corn that can be produced is 4 units; if all resources are used to produce cotton, at most 10 units of cotton can be produced.

The curve joining all such points is called the production possibility frontier (PPF), or production possibility curve (PPC). It gives the maximum amount of corn that can be produced for any given amount of cotton, and vice versa.

Any point on or below the curve represents a combination that can be produced with the economy's resources. A point strictly below the curve represents a combination produced when some resources are underemployed or wasted.

Every economy must choose one of the many production possibilities that it has: this is itself one of the central problems of the economy.

The horizontal axis measures corn and the vertical axis measures cotton.

Points A, B, C, D and E from the table are plotted and joined to form a curve bowed outward from the origin (concave to the origin), running from point A on the cotton axis to point E on the corn axis.

Any point on the curve shows full and efficient use of resources; any point inside the curve shows underemployment or wasteful use of resources; any point outside the curve is not attainable with the current resources and technology.

What are the assumptions and features of the production possibility curve?

The curve is drawn on a few simple assumptions. The economy produces only two goods, here corn and cotton. The total amount of resources available to the economy is given and fixed. The stock of technological knowledge is given and does not change while the curve is drawn. The resources are fully and efficiently utilised.

Its main features follow from these assumptions. The curve slopes downward from left to right, because more of one good can be produced only by giving up some of the other.

The curve is concave to the origin, because the opportunity cost of producing more of one good rises as more of it is produced, since resources are not equally suited to producing both goods.

Any point on the curve shows full and efficient use of resources, any point inside it shows underemployment or wasteful use, and any point outside it is unattainable with the given resources and technology.

A general improvement in technology or an increase in total resources shifts the whole curve outward, while a technological change affecting only one good rotates the curve around its end point on the other good's axis.

What is opportunity cost, and how does the PPC show it?

If more scarce resources are used to produce corn, fewer resources remain for cotton, and vice versa.

There is therefore always a cost of having a little more of one good in terms of the amount of the other good that has to be forgone.

This is called the opportunity cost of an additional unit of the good; because of its importance it is sometimes also called the economic cost. The concept applies to individuals as well as to society as a whole.

Definition: Opportunity cost. The amount of one good that must be given up to produce one additional unit of another good, when resources are fully and efficiently employed.

Worked example 1. Using the table above, the economy moves from possibility C (2 units corn, 7 units cotton) to possibility D (3 units corn, 4 units cotton).

Answer: Corn produced rises by 3 − 2 = 1 unit, while cotton produced falls by 7 − 4 = 3 units. The opportunity cost of producing the 3rd unit of corn is therefore 3 units of cotton.

Worked example 2. The economy next moves from possibility D (3 units corn, 4 units cotton) to possibility E (4 units corn, 0 units cotton).

Answer: Corn rises by 4 − 3 = 1 unit, while cotton falls by 4 − 0 = 4 units.

The opportunity cost of the 4th unit of corn is 4 units of cotton, which is higher than the 3 units of cotton given up for the 3rd unit.

The opportunity cost of corn rises as more corn is produced, which is why the curve is bowed outward (concave to the origin).

Worked example 3. Suppose the economy actually produces only 2 units of corn and 5 units of cotton, instead of the 7 units of cotton shown at possibility C for the same 2 units of corn.

Answer: This point lies strictly below the production possibility curve. It shows that some resources are either underemployed or used in a wasteful fashion, because the economy could produce 2 units more cotton (7 instead of 5) without giving up any corn, simply by using its resources fully and efficiently.

Worked example 4. Suppose a government has a fixed development budget of ₹500 crore to allocate between primary education and road building, and it has already decided on an allocation of ₹300 crore to education and ₹200 crore to roads.

Answer: Any increase in the amount spent on roads, say to ₹250 crore, must be matched by a fall in the amount available for education, to ₹250 crore, since the total budget of ₹500 crore is fixed.

The ₹50 crore of education spending given up is the opportunity cost of the extra ₹50 crore spent on roads, illustrating that "what to produce" decisions always involve a trade-off when resources are scarce.

How does technology cause a shift of the PPC?

The production possibility frontier is drawn for a given stock of technological knowledge and a given amount of resources.

If technology improves generally, or if the total quantity of resources available to the economy increases, the economy becomes capable of producing more of both goods than before.

This is shown as an outward shift of the whole production possibility curve: every point on the new curve lies further from the origin than the corresponding point on the old curve, because the maximum attainable amount of both corn and cotton has increased.

A shift of this kind means that combinations that were previously unattainable, lying outside the old curve, become attainable with the new, larger stock of resources or improved general technology.

The original curve from A to E is drawn first.

A new curve is drawn further from the origin on both axes, for example running from a higher point on the cotton axis to a higher point on the corn axis, showing that more of both corn and cotton can now be produced at every combination because of a general improvement in technology or an increase in total resources.

How does technology cause a rotation of the PPC?

Technology may also improve in a way that affects only one good. If a new technology raises only the maximum amount of cotton that can be produced, while the maximum amount of corn that can be produced alone stays the same, the production possibility curve does not shift outward on both axes equally.

Instead, it pivots, or rotates, around the point on the corn axis that shows the maximum corn obtainable: the end point on the cotton axis moves further out, showing a higher maximum cotton output, while the end point on the corn axis stays fixed.

Such a rotation shows that a change in technology affecting only one good changes the trade-off between the two goods along the curve, without changing the maximum amount of the other good that can be produced if all resources are devoted to it alone.

The horizontal axis shows corn and the vertical axis shows cotton. The point where the curve meets the corn axis (maximum corn alone) stays fixed.

The point where the curve meets the cotton axis moves further up, showing a higher maximum cotton output, because an improvement in cotton-producing technology alone has rotated the curve outward only on the cotton side.

Going beyond the syllabus

This idea looks more closely at one feature of the curve, its bowed-out shape.

Why is the production possibility curve bowed outward?

The underlying reason the production possibility curve is bowed outward, rather than a straight line, is that resources are not equally suited to producing every good.

As an economy devotes more and more resources to corn, it has to draw in resources, such as land or labour, that are better suited to cotton, so each extra unit of corn costs more units of forgone cotton than the last.

This pattern is sometimes called the law of increasing opportunity cost, and it is the reason the curve becomes steeper as more corn is produced, as seen when comparing the opportunity cost at C to D with that at D to E in the worked examples above.

Glossary

• Goods — physical, tangible objects used to satisfy people's wants and needs, contrasted with services.
• Services — the intangible satisfaction of wants and needs, such as the tasks performed by doctors and teachers.
• Resource — goods and services used to produce other goods and services, such as land, labour, tools and machinery.
• Scarcity — the limitation of resources available to an individual or society compared with its wants.
• Choice — the necessity of selecting among competing uses of scarce resources because not all wants can be satisfied at once.
• Allocation of resources — deciding how much of which resource is devoted to producing each of the different goods and services.
• Production possibility set — all possible combinations of goods and services that can be produced from a given amount of resources and technology.
• Production possibility frontier — the curve showing the maximum combinations of two goods that can be produced when resources are fully utilised.
• Opportunity cost — the amount of one good given up to produce one more unit of another good.
• Efficient use of resources — using resources fully, so that production takes place on, not inside, the production possibility frontier.
• Underemployment of resources — a situation where resources are not fully or properly used, shown by a point strictly below the production possibility curve.
• Shift of the PPC — an outward (or inward) movement of the whole curve caused by a general change in technology or in the total quantity of resources.
• Rotation of the PPC — a pivoting of the curve around one axis caused by a technological change affecting the production of only one good.
• Central problems of an economy — the questions of what to produce, how to produce, and for whom to produce.

Common errors and misconceptions

• Misconception: The production possibility curve is a straight line. Correct: It is normally drawn bowed outward (concave to the origin) because the opportunity cost of producing more of one good rises as more of it is produced.
• Misconception: A point inside the production possibility curve is simply impossible. Correct: A point inside the curve is attainable; it shows that resources are being underemployed or used wastefully, unlike a point outside the curve, which is genuinely unattainable with current resources and technology.
• Misconception: Any improvement in technology always shifts the whole curve outward equally. Correct: A general improvement in technology or in total resources shifts the whole curve outward, but an improvement that affects only one good's production rotates the curve instead.
• Misconception: Opportunity cost only applies to businesses, not to individuals. Correct: The concept applies to the individual as well as to society as a whole, whenever scarce resources are used for one purpose instead of another.
• Misconception: "What to produce" and "how to produce" are the same question. Correct: "What to produce" concerns which goods and in what quantities, while "how to produce" concerns which combination of resources and technology is used to produce them.
• Misconception: Scarcity means there is an absolute shortage of a good in the world. Correct: Scarcity means resources are limited relative to the wants they must satisfy, not that a fixed small amount exists in an absolute sense.

Exam-style questions with model answers

Q1. Choose the correct option. The problem of scarcity and choice is faced by: (a) only market economies (b) only centrally planned economies (c) all economies, whatever their economic system (d) only poor economies [1 mark]

1. (c) all economies, whatever their economic system. Scarcity and choice are universal in character, because every economy has resources that are limited compared with what its people collectively want.

Q2. State the three basic problems of an economy. [1 mark]

1. What to produce and in what quantities, how to produce, and for whom to produce.

Q3. Given below are two statements marked Assertion and Reason. Read the statements carefully and choose the correct option. Assertion: The problem of scarcity and choice is universal in character. Reason: Resources are limited in comparison with wants in every economy, irrespective of the economic system it follows. (a) Both Assertion and Reason are true, and Reason is the correct explanation of Assertion. (b) Both Assertion and Reason are true, but Reason is not the correct explanation of Assertion. (c) Assertion is true but Reason is false. (d) Both Assertion and Reason are false. [1 mark]

1. (a) Both Assertion and Reason are true, and Reason is the correct explanation of Assertion. Every economy, whatever its system, has scarce resources and so must choose how to use them.

Q4. An economy producing corn and cotton can achieve the following combinations when its resources are fully used: possibility C gives 2 units of corn and 7 units of cotton; possibility D gives 3 units of corn and 4 units of cotton. Calculate the opportunity cost of producing the 3rd unit of corn. [4 marks]

1. Opportunity cost is the amount of one good given up to produce one more unit of another good, when resources are fully and efficiently employed.
2. Moving from possibility C to possibility D, corn produced rises from 2 to 3 units, an increase of 1 unit.
3. Over the same move, cotton produced falls from 7 to 4 units, a fall of 3 units.
4. The opportunity cost of producing the 3rd unit of corn is therefore 3 units of cotton forgone.

Q5. Distinguish between a shift of the production possibility curve and a rotation of the production possibility curve. [4 marks]

1. A shift of the production possibility curve is an outward movement of the whole curve, in which every point moves further from the origin on both axes.
2. A shift is caused by a general improvement in technology or by an increase in the total quantity of resources available to the economy, allowing more of both goods to be produced.
3. A rotation of the production possibility curve is a pivoting of the curve around the point on one axis, where the end point for one good stays fixed while the end point for the other good moves outward.
4. A rotation is caused by a technological change that affects the production of only one of the two goods, rather than both goods generally.

Q6. Explain the three central problems that every economy must solve. [8 marks]

1. Every economy faces scarcity of resources compared with what people collectively want, so it must decide how to use its limited resources.
2. What to produce: the economy must decide how much of each of the many possible goods and services to produce, for example whether to produce more food and clothing or more luxury goods.
3. It must also decide whether to favour consumption goods or investment goods such as machines, which will boost production and consumption tomorrow.
4. How to produce: the economy must decide which combination of resources, such as labour or machines, to use in producing each good or service.
5. It must also decide which of the available technologies to adopt in the production of each good.
6. For whom to produce: the economy must decide how the goods and services produced are to be distributed among individuals, and who gets more and who gets less.
7. It must decide whether to ensure a minimum amount of consumption for everyone, and whether elementary education and basic health services should be available freely for everyone.
8. These three problems arise together because the allocation of scarce resources to different goods and the distribution of the resulting output are the central economic problems faced by any society.

Q7. A new storage technology allows a cotton-producing region to raise the maximum cotton output obtainable from its resources, without changing the maximum amount of corn obtainable if all resources were devoted to corn alone. Analyse how this changes the production possibility curve. [4 marks]

1. Since the new technology affects only cotton production, the point where the curve meets the corn axis, the maximum corn obtainable alone, remains unchanged.
2. The point where the curve meets the cotton axis moves further out, since the maximum cotton obtainable alone has risen.
3. The curve therefore rotates outward on the cotton side around the fixed corn-axis point, rather than shifting outward equally on both axes.
4. This shows that a technological change affecting only one good changes the trade-off between the two goods along the curve, without changing the maximum amount of the other good obtainable.

Q8. A certain combination of corn and cotton produced by an economy is found to lie strictly below its production possibility curve. Explain what this indicates about the use of the economy's resources. [4 marks]

1. It indicates that the economy's resources are either underemployed or are being used in a wasteful fashion.
2. More of at least one good could be produced without giving up any of the other, simply by using resources fully.
3. It shows that the economy is not making efficient use of its resources, because efficient use requires production to take place on the production possibility frontier itself.
4. For example, an economy producing 2 units of corn and 5 units of cotton could produce 7 units of cotton with the same 2 units of corn if its resources were fully and efficiently used.

Q9. Evaluate the view that the problem of scarcity and choice would disappear in a centrally planned economy. [8 marks]

1. Scarcity means that resources are limited in comparison with the wants they must satisfy, and this is true of every economy.
2. In a centrally planned economy the government or central authority plans all the important activities and makes the important decisions about production, exchange and consumption.
3. Planning changes the way the basic problems are solved, but it does not remove the limited supply of resources.
4. The central authority still has to decide what to produce and in what quantities, how to produce, and for whom to produce.
5. It may try to achieve a particular allocation of resources and a distribution of the final combination of goods and services that it thinks desirable for society as a whole.
6. It may, for example, induce individuals to produce more of an important good such as education or health, or produce it itself.
7. It may also intervene to achieve a more equitable distribution if some people get so small a share that their survival is at stake.
8. Since resources remain scarce in every system, the problem of scarcity and choice is universal and does not disappear under central planning; only the mechanism for solving it changes.

Key takeaways

• Scarcity of resources compared with wants forces every individual and every society to make choices.
• The problem of scarcity and choice is universal: it is faced by all economies, whatever economic system they follow.
• Every economy faces three central problems: what to produce, how to produce and for whom to produce.
• The production possibility frontier shows the maximum combinations of two goods obtainable when resources are fully and efficiently used.
• A point inside the curve shows underemployment or wasteful use of resources; a point outside it is unattainable.
• Opportunity cost is the amount of one good forgone to produce one more unit of another good.
• The curve is usually concave to the origin because opportunity cost rises as more of a good is produced.
• A general improvement in technology or in total resources shifts the whole curve outward.
• A technological change affecting only one good rotates the curve around its end point on the axis of the unaffected good.
• Efficient use of resources means producing on the frontier, not inside it.

Test yourself

What is scarcity?

Scarcity is the situation where the resources available to an individual or society are limited compared with the wants they must satisfy, forcing choices to be made.

Name the three central problems every economy must solve.

What to produce and in what quantities, how to produce it, and for whom it should be produced.

Why is the problem of scarcity and choice called universal?

Because it is faced by all economies, irrespective of the economic system they follow, since resources are limited compared with wants everywhere.

What does a point lying strictly below the production possibility curve show?

It shows that resources are either underemployed or being used in a wasteful fashion, so more output could be obtained without extra resources.

Define opportunity cost.

Opportunity cost is the amount of one good that must be given up to produce one additional unit of another good.

State two assumptions on which the production possibility curve is drawn.

The total amount of resources available to the economy is given and fixed, and the stock of technological knowledge is given and unchanged.

What is the difference between a shift and a rotation of the PPC?

A shift moves the whole curve outward due to a general change in technology or resources; a rotation pivots the curve around one axis due to a change affecting only one good.

What does efficient use of resources mean on a PPC diagram?

It means the economy is producing on the frontier itself, rather than at a point inside it, so no good can be increased without reducing another.

If an economy's resources increase overall, what happens to its PPC?

The whole production possibility curve shifts outward, since more of both goods can now be produced than before.